Educational Articles

Prescription for Growth: Take 250 or so of These and Call Us in the Morning

Andre J. Costanza
| February 23, 2010

Already one of the nation’s premiere drug retailers, with more than 7,100 stores spanning all 50 states, Walgreen (WAG) has decided to take a bite out of the big apple. Indeed, the company recently announced that it would buy New York-based Duane Reade and its 257 stores for just shy of $1.1 billion, including the assumption of $457 million in debt. The deal is expected to close by August 31, 2010, Walgreen’s fiscal year end.

Although the Walgreen story, by historical measures, has been one of organic growth, it has more recently broadened its strategic arsenal and embraced acquisitions as a means of increasing its customer base and expanding its reach into new niches and areas. The most recent purchase of Duane Reade exemplifies the evolution of the management team and its strategy, and lays credence to our view that Walgreen will be at the forefront of this industry for decades to come. Indeed, the announcement is a clear signal to the competition, specifically CVS Caremark (CVS), which, following its industry changing marriage in late 2007, has been slowly making its way to the New York City area, that Walgreen will not be bullied and is up to the task of competing on the grandest stage.

Privately held Duane Reade operates almost exclusively in the tri-state area, with a particular stronghold in the New York metropolitan area. It has stores on just about every corner of what just so happens to be the most lucrative market in the U.S. Its customers tend to be very loyal, enabling the chain to produce some pretty impressive metrics according to industry standards. (Its sales per square foot are tops in the retail drug industry.) For this reason, Walgreen plans on maintaining the Duane Reade moniker for now.

Either way, the deal is a major boon for Walgreen, giving it fairly quick and relatively inexpensive access to the Empire State, an area into which pricey real estate has kept it from making significant inroads. Although management says that the merger will be dilutive to earnings in the first year after closing (prompting us to slightly trim our fiscal 2010 earnings estimate), it ought to be a major contributor for years after, providing annual cost savings in the neighborhood of $125 million after all the kinks are worked out. Walgreen is, along with CVS, the gold standard in the drug retail space. Its stores are brightly lit and inviting. Aisles are wide and clutter-free, with shelves that are fully stocked and in order. Duane Read locations, on the other hand, if you haven’t had the opportunity to shop at one, tend to be home to a less shopper-friendly ambiance. Stores are generally dark, poorly stocked, and cluttered, making for a far less enjoyable shopping experience, in our opinion. Even Duane Reade appears to have recognized the problem with newer stores appearing to address the issues. However, there is still room for much improvement and Walgreen should benefit from putting a few finishing touches on the newest stores in its collection.

The drug retail space remains one of much interest. An aging population, ongoing medical advances, and a growing need for prescription drugs paints a favorable backdrop for most here, but especially industry leaders, such as Walgreen. Although we’ve tempered our near-term outlook to account for the trials and tribulations that will likely be associated with the aforementioned merger, we look for Walgreen to post solid earnings growth this year, with further improvement in 2011.

Wall Street showed little interest in the Duane Reade deal, and we think that was a mistake. We believe liquidity concerns are overblown and expect the endeavor to pay off in spades out to 2013-2015. That said, we would not be surprised to see further industry consolidation. Rumors are circulating that Rite Aid (RAD) may be on the block with CVS and even retail behemoth Wal-Mart (WMT), which has thrown its hat in the prescription-drug ring, mentioned as potential suitors.